Recovery is under way but can it be sustained? UNECE launches its Economic Survey of Europe, 2004 No. 1

Geneva

Economic growth in the ECE region is forecast to accelerate in 2004, but there are significant differences in the expected growth performance of the major countries and subregions. Forecasts are for robust and strengthening growth in North America and eastern Europe and even for a continuing boom in the CIS. This contrasts with only moderate growth prospects for the aggregate of western European countries, especially the euro area.

But the outlook remains clouded by important downside risks. These are largely related to the persistence of a very large current account deficit in the United States, which in combination with a sizeable government budget deficit could trigger abrupt changes in the direction of capital flows and accentuate the fall of the dollar witnessed since early 2002. There are notably concerns that a further marked appreciation of the euro could act as a brake on the fragile recovery in the euro area.

The main challenge for governments, therefore, is how to ensure both a sustained global recovery and a steady and progressive correction of the United States current account deficit and the corresponding surpluses of its trading partners.

A global recovery is underway, led by the United States...

There is increasing evidence that a global recovery finally took hold in the second half of 2003. The recovery is being led by the United States, where economic activity accelerated in 2003, supported by robust domestic demand, largely reflecting a very expansionary economic policy. Real GDP rose by 3.1 per cent in the United States in 2003 compared with the preceding year. Additional support for the global recovery has come from the cyclical upturn in Japan and the continued strong growth in Asian emerging markets, notably China and India. In the United Kingdom, moreover, economic growth has regained strong momentum and continues to be more closely aligned with the United States' growth cycle rather than with that in continental Europe.

...but economic activity in the euro area remained sluggish in 2003

The forces for a recovery still look fragile in the euro area, where domestic demand has remained weak and the impact of the sharp appreciation of the euro on exports has been offsetting the stimulus from an easing of monetary policy. Economic activity has been particularly sluggish in France, Germany and Italy, the three major economies of the euro area. The aggregate fiscal policy stance in the euro area was slightly restrictive in 2003.

In the euro area, which remained the principal "weak spot" of the global economy in 2003, real GDP rose by only 0.5 per cent. For the European Union as a whole, real GDP rose by 0.8 per cent in 2003, slightly more than for the euro area because of the resilient United Kingdom economy. For western Europe, the aggregate annual rate of economic growth was 0.9 per cent in 2003, down from 1.3 per cent in the preceding year (table 1).

The disappointing overall performance of most of the current EU member States contrasts with the strong economic growth in the ten countries that will be joining the Union in May 2004. Real GDP in these ten countries combined rose by 3.6 per cent in 2003, up from 2.5 per cent in 2002 (table 1). Had these countries already been members in 2003, annual growth of real GDP in the enlarged Union would have been 1 per cent, i.e. 0.2 percentage points higher than for the EU-15. This small improvement reflects the relatively small economic weight of the accession countries, which currently account for only some 5 per cent of the nominal GDP of the enlarged EU.

Growth in eastern Europe strengthens...

Aggregate GDP growth in eastern Europe accelerated to 3.8 per cent in 2003, almost one percentage point more than a year earlier (table 2). This was largely due to the recovery in eastern Europe's largest economy Poland: after two years of near stagnation, growth in Poland gained momentum during the year and GDP rose by 3.7 per cent.

For the region as a whole, domestic demand remained (as in 2001 and 2002) the principal source of growth; with very few exceptions, net exports pulled down the growth of output. Thanks to the ongoing restructuring of the east European economies and the expansion of their productive capacity, domestic suppliers were able to benefit from the strong domestic demand. Improved financial intermediation and an expanding credit market, a consequence of successful banking reforms, also contributed to the general strengthening of economic activity in the region.

... and CIS economies are booming

After some deceleration in 2002, economic activity in the CIS region surged in 2003, led by rapid growth in Russia. Aggregate GDP in the CIS grew by 7.6 per cent, making it one of the fastest growing regions in the world. A combination of favourable external conditions (especially higher export prices for oil and gas) and a continuing strong recovery in domestic demand contributed to this outcome. The enduring buoyancy in domestic demand - reflecting growing consumer and investor confidence in many of the CIS economies - is a sign that the difficult reforms in these transition economies are finally starting to bear fruit.

The average rate of growth in the CIS reflects the strong performance of the region's largest economies, Russia, Ukraine and Kazakhstan, where GDP increased by 7 to 9 per cent (table 2). Apart from the factors outlined above, the strong upturn in Russia was also underpinned by an expansionary monetary policy. There were also signs of a deeper and more extensive restructuring of the Russian enterprise sector, partly in response to growing competitive pressure.

The short-term outlook is for higher economic growth in western Europe and North America but cyclical growth forces continue to differ significantly

World economic activity is expected to strengthen further in 2004. World output growth is set to exceed 4 per cent, up from 3¼ per cent in 2003. This should be accompanied by a marked acceleration in the volume growth of world merchandise trade to some 8 per cent, twice the rate in 2003.

In the United States, economic growth is forecast to accelerate to an average annual rate of about 4.5 per cent in 2004 (table 1). The recovery should continue to be supported by the strong growth of domestic demand and an accommodative economic policy. Exports are expected to grow briskly supported by the depreciation of the dollar and a broadening global recovery. These external influences on GDP, however, are likely to continue to be more than offset by the strong growth of imports. The Federal Reserve is expected to keep its target for the federal funds rate at 1 per cent until there are firmer indications of a self-sustaining recovery. Fiscal policy will probably remain expansionary, but the fiscal impulse should diminish significantly, given that most of the output gap is likely to disappear in 2004 and in view of the significant deterioration of the medium-term fiscal outlook.

In the euro area, recovery is expected to gain some momentum in the course of 2004. Real GDP is currently forecast to rise by 1.9 per cent. This reflects a pick-up in export growth and a strengthening, albeit moderate, of final domestic demand growth, partly due to a slight upturn in business fixed investment. Continued weak growth of private consumption expenditures remains a major factor behind the moderate prospects for overall economic growth. Exports should benefit from the stronger growth in world trade, which should help to offset the dampening effects of the recent appreciation of the euro in real effective terms. Changes in the volume of net exports, however, are likely to have a broadly neutral effect overall as a result of the stimulus to imports from the stronger euro.

Monetary policy is assumed to remain broadly accommodative in view of the restraining effects of the real effective appreciation of the euro and the favourable inflation forecast. In view of the strong appreciation of the euro, which is unlikely to be reversed in 2004, a lowering of interest rates would now appear to be necessary to avoid a further tightening of monetary conditions let alone to provide a monetary relaxation. This is all the more necessary, because fiscal policy is set to be broadly neutral in 2004.

Growth in eastern Europe and the CIS is set to remain buoyant in 2004

Eastern Europe and the CIS are poised to remain the most dynamic parts of the ECE region in the short run. While GDP growth in eastern Europe is expected to accelerate to some 4.5 per cent, in the CIS it is set to slow down to 5.7 per cent in 2004, a rate similar to that in 2001 and 2002 (table 2).

In 2004, growth should accelerate in most east European economies. These generally optimistic forecasts reflect expectations of a strengthening recovery in western Europe, which is their main export market. The new EU members should also benefit from positive effects of EU accession on business and consumer sentiment. The acceleration of FDI-led restructuring in some of the south-east European countries has strengthened the supply side of their economies, and this provides a basis for a sustained recovery in the coming years. Most countries in eastern Europe are relying on stronger demand for their exports in 2004 (than was the case in the previous two years) not only to support domestic activity but also as a way to revert to a more balanced pattern of growth: a shift towards export-led growth should help to reduce the existing external deficits.

In the CIS, some moderation of growth is expected in 2004, reflecting expectations of a slowdown in the region's largest economies. Economic activity in Russia should generally remain buoyant in 2004 but GDP growth is set to slow down slightly, to some 5-6 per cent, mostly due to a more moderate expansion in the oil sector. A similar pattern is also expected in other CIS economies but despite the deceleration, output growth should generally remain robust throughout the region. Strong domestic demand will continue to be an important source of growth for the CIS economies.

But there remain important downside risks to the short-term outlook in the ECE region...

Although the baseline forecast is for a sustainable global recovery in 2004 and its continuation in 2005, the short-term economic outlook remains, nevertheless, vulnerable to important downside risks.

A major source of uncertainty is the sustainability of the recovery in the United States, given its strong impact on economic growth in the rest of the world. Downside risks continue to be associated with the persistently high level of private household debt and the ongoing boom in the housing market, which helped to sustain personal consumption growth. Another uncertainty is the currently much weaker link between economic growth and employment compared with previous recoveries, at least so far. If new job creation continues to be lower than expected, it could dampen consumer confidence and spending propensity. Persistently large fiscal deficits could, moreover, trigger a rise in United States long-term interest rates, which would probably spill over to the euro area and Japan, with adverse consequences for interest-sensitive expenditure items.

... largely related to the considerable United States current account deficit...

A persistent source of worry is the large current account deficit, which now corresponds to 5 per cent of GDP, the highest level on record. Concerns in international financial markets about the sustainability of the current account deficit are reflected in the pronounced weakening of the dollar since early 2002. In the face of a persistently large current account imbalance, therefore, the risk of sudden and disruptive capital flows and the associated changes in exchange rates (especially an accelerated weakening of the dollar) cannot be excluded.

The problem is that the weakness of the dollar has occurred at a time when the recovery in both the euro area and Japan is still fragile, and when both, to a large extent, are relying on an initial strong impulse from foreign demand. A dilemma is that the adjustment of the United States current account imbalance cannot be brought about by the exchange rate alone. What is also required is a stronger rate of growth of domestic demand in the rest of the world and a sustained increase in the United States national savings rate.

Persistent weakness of domestic demand in the rest of the world puts disproportionate emphasis on the exchange rate as a means of adjustment. There is therefore a risk that the dollar depreciation will overshoot in 2004 and choke off the recovery in Europe and Japan, via its adverse impact on exports, profits and business investment.

In western Europe, the successive downward revisions of (already moderate) growth forecasts risk having a negative effect on long-term growth expectations in the business sector, with attendant negative effects on productive investment and the growth of potential output. The ambitious goals of the EU Lisbon strategy now look increasingly elusive and are likely to be even more out of reach after enlargement. While the need for supply-side reforms is undisputed, they need to be complemented with a coherent macroeconomic policy framework that is conducive to economic growth.

The euro area needs a more flexible fiscal policy framework

It is therefore important that the envisaged reform of the Stability and Growth Pact finds an appropriate balance between the need to ensure fiscal sustainability over the medium and longer term and sufficient flexibility for fiscal policy to support economic growth (see below). A broader mandate for the ECB - emphasizing the importance of giving due attention to both inflation and the growth of employment - would also be helpful.

In the euro area, apart from the concern that a stronger euro could choke off the recovery, business investment could be held back by the lingering balance sheet problems in the corporate sector in several countries, especially France, Germany and Italy. Another uncertainty is how far households' spending propensities will be affected by the long-standing discussions about future pension entitlements and the funding of rising health care costs. There has also been a sizeable increase in household debt in recent years, largely related to a surge in house prices in several countries (notably Greece, Ireland, the Netherlands and Spain). As in the United Kingdom and the United States, there is a risk that rising interest rates could trigger a fall in house prices with adverse effects on consumer spending.

Macroeconomic imbalances need to be corrected in eastern Europe...

The most serious external risk for eastern Europe is the presently lacklustre west European import demand that, if it fails to improve, could disappoint east European hopes of robust export growth. The existing macroeconomic imbalances are another important source of downside risks: policy makers are under increasing pressure to take action to correct large and sometimes growing current account deficits. In addition, if efforts to consolidate the public finances in central Europe fail to reduce the large fiscal deficits, a further tightening of monetary policy may be the prospect. In the short-run, such policy responses are likely to have negative consequences for economic activity in the countries involved.

... and in the CIS

Apart from the uncertainties surrounding world commodity markets, there are also additional downside risks to the short-term outlook for the CIS economies. Macroeconomic imbalances in some of them may prompt governments to tighten macroeconomic policies (after a general relaxation in 2003), and this could lead to some moderation in growth rates. Some of the more indebted CIS economies may encounter balance of payments constraints that could further weaken their growth. Finally, if Russia's growth falls below expectations, there will be negative repercussions for all the other economies in the region.

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Selected policy issues

(i) The Stability and Growth Pact must be reformed

The causes of the current crisis concerning the fiscal rules of the Economic and Monetary Union (EMU) can be traced in part to the sins of omission in good economic times a few years ago, when some countries failed to exploit the available scope for fiscal consolidation. But the current crisis has also to be seen against the background of a persistent controversy surrounding the EMU's fiscal rules ever since the adoption of the Stability and Growth Pact in 1997. This controversy is not so much about the need for fiscal rules in a monetary union, but rather about their specific design.

A major problem is that EU member States differ significantly in their economic structures, and this in turn affects their longer-term economic potential. The economic rationale for imposing a one-size-fits-all fiscal policy framework thus appears highly questionable. Such an approach will become even more difficult to justify after the enlargement of the EU in May 2004, which will lead to a further increase in the heterogeneity of economic structures across the EU membership.

The major elements that an envisaged reform should include can be summarized as follows:

The creation of an effective mechanism for controlling the growth of government debt beyond a certain agreed limit (as a per cent of GDP);

A shift in the focus of the budgetary surveillance process from annual budget deficit targets to multi-annual (e.g. five-year) targets;

A review of the too restrictive definition of "exceptional circumstances" that allow the 3 per cent budget deficit threshold to be exceeded (if the latter is to be upheld);

A waiver of the 3 per cent budget deficit ceiling for countries with low and clearly sustainable levels of debt;

The introduction of the golden rule, i.e. to allow borrowing for the financing of public investment; Allowing automatic stabilizers to operate freely in a cyclical downturn;

The control of fiscal profligacy in periods of strong growth;

A mechanism for ensuring non-partisan assessment of compliance (or non-compliance) with the fiscal rules.

The main requirement of any reform of the SGP is to create a coherent set of fiscal rules that combine sufficient flexibility for fiscal policy to stabilize economic activity in the short run with a mechanism that prevents an excessive growth of government debt in the medium and longer term. Reform of the SGP should aim for a more flexible framework that, to the greatest extent possible, should allow for the differential treatment of countries based on commonly agreed principles and transparent fiscal sustainability criteria. To ensure broad political support for the reformed fiscal framework, considerable efforts must be made to explain its rationale and functioning to the wider European public.

But the ultimate test is not whether governments can be held to the rules but whether the rules can ensure - or ease the way to - better economic performance and improved levels of welfare. If they are seen to obstruct such improvement - and this will be especially important for the new EU members - then the framework will lose legitimacy and eventually collapse.

(ii) The countries acceding to the EU face new challenges

EU membership entails major new policy responsibilities for the acceding east European countries. One of the key challenges in the area of macroeconomic policy lies in their preparation for EMU accession, which requires that the applicants comply with the Maastricht criteria. Progress by the acceding countries in meeting these has been mixed. In particular, large fiscal deficits are a major problem for most of the central European countries. The Maastricht criteria also require participation - without severe tensions - for at least two years in the EU's exchange rate mechanism ERM-2 prior to EMU entry. However, this type of monetary regime carries potential risks for the economies that join it. The combination of a fixed (although adjustable to some extent) exchange rate and the absence of capital controls leave local financial markets vulnerable to volatile movements of speculative capital. This was clearly demonstrated by the experience of Hungary (a country that runs an exchange rate regime similar to ERM-2) in 2003. The choice of policies towards EMU accession remains one of the most debated issues in the acceding countries. While initially a number of acceding countries were aiming at fast EMU accession, most of them now envisage a further preparatory period of some four to five years after accession to the EU.

The policy debate over the strategy for joining the euro area also raises the question as to whether the Maastricht criteria in their present form should be applied to the new EU members. Thus the presence of higher inflation, which is related to a productivity catch-up and is not rooted in lax policy, could justify a reinterpretation of the Maastricht inflation criterion. Another relevant issue is that the acceding east European economies still suffer from poor infrastructure and hence more public investment could improve considerably their growth prospects. In turn, this would justify a reinterpretation of the required deficit target for these economies in terms of the "golden rule" of public finance, that is, the allowed deficit should be net of debt-financed public investment.

(iii) Towards closer economic integration in the CIS

In September 2003, the Heads of State of the four largest CIS economies, Belarus, Kazakhstan, Russia and Ukraine, signed an agreement stipulating the establishment of a Single Economic Space (SES) among them. The framework agreement envisages broad ranging economic integration: establishment of a free trade area among the participating countries (free movement of goods, services, capital and labour); unification of internal technical norms and standards; harmonization of macroeconomic policy; harmonization of all legislation and regulations related to the functioning of the SES in the member States.

SES is the most ambitious initiative for economic integration (compared with several previous ones) among the CIS countries. For the first time, it spells out clearly the goal of establishing a common economic area that has all the essential features of an economic union. The main unknown, however, is to what extent this agreement will actually be put into effect and how fast the four countries will be willing and able to move towards closer economic integration. The lessons from past similar attempts (as well as from the EU's rich experience in advancing economic integration) suggest that policy makers in the founding members of the SES should carefully define their joint economic interests and focus their initiatives along these common interests. The successful creation of a functioning free trade area will probably be a necessary first step before the member States can turn to more advanced levels of integration.